Comparison of Absorption Costing and Marginal Costing

1. The value of closing stock is small under marginal costing because only variable costs are considered for valuation.

2. The same amount of profit is reported under absorption costing and marginal costing if the production is equal to sales. The reason is that fixed factory (manufacturing) overheads charged to the period were the same in each case.

3. If the production is more than the sales, more profit is reported under absorption costing. The reason is that the value of closing stock includes a portion of the fixed costs of current period and shifted to the following period.

4. If the production is less than the sales, less profit is reported under absorption costing. The reason is that previous period fixed cost is included in the opening stock and charged against current revenues.

5. The profit under marginal costing moves always in the same direction as sales volume. In the case of absorption costing, profit
behave irregularly and sometimes in the opposite direction from sales.

The following summarizes the profit reported under absorption and marginal costing.

If Production = Sales; Absorption profit = marginal costing profit.

If Production > Sales; Absorption profit > marginal costing profit.

If Production < Sales; Absorption profit < marginal costing profit.

If production fluctuates and sales are constant; absorption profit fluctuates and marginal costing profit is constant.

If production is constant and sales fluctuates; both profits vary in the direction of sales.

Differences between Absorption and Marginal Costing

The followings are the differences between absorption costing and marginal costing.

1. Product Costing

Both fixed and variable costs are treated as product costs under absorption costing. But, in the case of marginal costing, only variable costs are treated as product costs.

2. Inventory Valuation

Under absorption costing, both fixed costs and variable costs are taken into consideration for valuation. But, under marginal costing, variable cost alone are taken into consideration for valuation.

3. Profit Concept

Profit is the difference between sales revenue and total cost under absorption costing. The managerial decision-making is based on this figure. But, in the case of marginal costing, the managerial decision-making is based on the contribution. The term contribution refers to the excess of sales revenue over marginal cost.

4. Under or Over-absorption of Overheads

Under absorption costing, fixed costs are treated as product costs. Hence, these are apportioned over the products arbitrarily which leads to the problem of under or over absorption of overheads. But in the case of marginal costing, such problem is not raised since fixed costs are excluded from the purview of product costs.

Importance of Absorption Costing

The absorption costing may be preferred on the following grounds.

1. The fixed costs are incurred for production purpose. Hence, the inclusion of fixed costs in the valuation of closing stock or products costs is justifiable.

2. If the fixed costs are not included in the valuation of inventory, fictitious loss is shown in the books of accounts when the goods are not sold and shown excessive profit in the books of accounts when goods are sold.

3. Profit fluctuations are less when production is constant but sales fluctuate.

4. There is a matching of costs and revenue. It is correct to match the costs with revenue.

5. The inclusion of fixed cost in the calculation of a total cost of a product helps the businessman to fix the price above the total cost.

Importance of Marginal Costing

Marginal costing may be preferred on the following grounds

1. Marginal costing technique is very easy to understand and operate.

2. The fixed costs are not taken consideration for the cost of production. This avoids complicated and misleading statements.

3. Profits are not overstated since fixed costs are not absorbed in unsold stock.

5. Management can take quality decision with the help of contribution details

6. The fixed costs are not apportioned on an arbitrary basis.

Limitations of Absorption costing or Total Cost Method

The following are the limitations of absorption costing.

1. Difficulty in Comparison and Control of Cost

Under absorption costing, different unit costs are obtained on different levels of output. If the level of output is increased, the unit cost is decreased and vice versa. This is due to inclusion of fixed costs. Hence, there is no possibility of comparison and control of cost.

2. No Use to Managerial Decisions

The top management people are very much interested to take a number of decisions like selection of suitable product mix, whether to buy a product or manufacture, whether to accept an export order or not, whether to fix the selling price below the total cost or not, number of units to be produced and sold to earn desired profit etc. The data provided by the absorption costing are not sufficient to take above mentioned type of decisions.

3. No Control of Fixed Cost

The closing stock is valued at cost of production, which includes fixed costs. The current year closing stock is the opening stock of next year. The closing stock will be sold in the years to come. If so, a portion of fixed cost is carried forward to the next year. Hence, there is no control of fixed cost.